'Too-Big-To-Fail' Banks May Be Next Hot-Button Issue

While Wall Street and the banking sector obsesses over the government’s controversial stress tests, Congress is moving on to the next hot-bottom issue—granting the government authority to take over and, if necessary, close big financial firms as part of a sweeping regulatory reform package.

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Sen. Chris Dodd (D-Conn.) Monday said the Senate Banking Committee will hold a public hearing Wednesday on the issue of so-called too-big-to-fail institutions, the first of what promises to be several hearings in Congress in the weeks to come. The House Financial Services Committee is expected to do the same as early as next week.

“It’s going to be the next big thing,” said one senior Congressional staffer.

In March, President Obama asked House Financial Services Chairman Barney Frank (D-Mass.) to fast-track legislation on the new regulatory power—similar to that which the FDIC now has over banks and thrifts with government-insured deposits—amid the latest public flap over executive pay at AIG , which has received tens of billions of dollars in government aid.

At the time, the plan was for the resolution authority measure to be drawn up as stand-alone legislation, and essentially rushed into law, but it will now be wrapped into a broader overhaul effort, including the creation a super or systemic regulator.

“We thought we could break that out and pass it sooner,” said one Congressional source, Congress is thought to be waiting for the White House to take the lead on the legislation and forward its recommendations to legislators.

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Both the Treasury and the Federal Reserve have submitted proposals to Congress, although only the Treasury has made its ideas public.

Supporters say resolution authority would close a dangerous and somewhat inexplicable hole in the government’s regulatory powers over large financial institutions other than commercial banks and would help prevent the messy collapse and collateral damage that occurred with Lehman Brothers last fall.

“The situation is showing us, we need more regulation,” says banking industry consultant Ken Thomas, who also teaches at the University of Pennsylvania’s Wharton School of Business.

Under current law, the FDIC uses its “bridge bank authority” to take control of a failing bank while arranging for a friendly takeover by another bank, which creates a relatively seamless change in operations and avoids a run on deposits.

In rare cases, the FDIC simply closes the bank and pays off depositors.

The FDIC, however, does not control bank-holding companies, the parent companies of the commercial banks.

That is the responsibility of the Fed, but the central bank is only legally allowed to make the company take "prompt corrective action" to deal with such things as capital requirements.

Under the Treasury’s proposal, the new authority would “enable the federal agency acting as conservator or receiver to sell or transfer the assets or liabilities of the institution in question, to renegotiate or repudiate the institution’s contracts (including with its employees), and to address the derivatives portfolio, thus reducing the potential for further disruption.”

Few doubt the need for all that after Federal Reserve Chairman Ben Bernanke last winter got the attention of one congressional panel looking into the industry’s escalating problems when he said: “I think what is missing is a comprehensive dissolution authority to address systemically critical firms.” Thus far, the financial services industry has been relatively supportive of the concept, but that doesn’t mean an easy ride for the legislation.

Analysts as well as former government officials say the regulatory reform package—and the resolution authority in particular—will be subject to power struggles within Congress and regulators.

There’s already been ample speculation about what regulator would get the new—and considerable—authority: The FDIC, the Fed and Office of the Comptroller of the Currency have all been mentioned.

There’s a case to be made for any of them and each have their champions, but analysts expect plenty of political infighting and jockeying along the way.

Some, however, say none of the above is the best course.

“If they have it, it has to be some kind of a new body,” says Thomas.The only current legal option is the bankruptcy court process, which entails either protection from creditors or outright liquidation, neither of which would work particularly well given the complicated counter-party nature of such complex operations, whose assets and liabilities now reach into the hundreds of billions.

Other analysts say expect fighting among congressional committees because the legislation spans apparent jurisdictions, covering core legal as well as financial issues, which is bound to attract the interest of House and Senate judiciary committees.

“You’re effectively shifting a not insignificant sector of the US economy from jurisdiction under the bankruptcy code,” says independent banking analyst Bert Ely, who predicts a "battle in Congress over authority.”

Still others are worried about the unintended consequences of such major legislation and are urging caution and due diligence all the way.

Given all those factors—as well as the other components of the overhaul package—Congressional sources say legislation may not be ready until the end of the year.

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